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Who'll Be Liable for Options?

A new proposal adds a dynamic twist to expensing stock options.

Someone better issue this advice to the executives at Intel(NASDAQ:INTC), Cisco(NASDAQ:CSCO), EMC(NYSE:EMC), and every company issuing stock options to employees: Accept FASB's proposal for one-time expensing of stock option grants.

While it's no secret I'm very negative on stock options (right up there with my hero, and Berkshire Hathaway(NYSE:BRK.a)(NYSE:BRK.b) chairman, Warren Buffett), I'm not convinced one-time option expensing is the right answer. Expensing underrepresents much of the true costs because it doesn't account for changes in the options' value over time.

Enter David Zion, accounting analyst at Credit Suisse First Boston, and his proposal to book options as a liability. In a nutshell, instead of expensing options once on the income statement, companies would mark-to-market a liability for unexercised options every quarter, booking the change in the liability as either income or expense. In my oh-so-humble opinion, this is more accurate because it highlights the fact that options usually end up worth many times the initial expense. And because the economics of the deal don't change, cash flow is unaffected. Technical accounting issues related to equity compensation and liabilities exist, but upcoming GAAP changes could potentially remove that roadblock.

Since Intel is the poster child for option excesses, let's use its first-quarter numbers as an example of what might happen under this proposal. First, Intel would take a $288 million charge for options granted in the quarter. Second, Intel had 592 million in-the-money options outstanding at quarter-end, at a weighted average exercise price of $18.95. (Assume no value on out-of-the-money options.) Assuming the change in Intel's stock price was the only factor affecting the options, the chip maker would book a gain of $2.7 billion, as the stock price fell $4.58 during the quarter. Sounds great, right?

Not necessarily. Since EMC's stock rose in the first quarter, under the same methodology, it would have taken total charges of $217 million, reducing per-share earnings from $0.06 to a loss of $0.03. Not quite as good, is it? Essentially, it works out such that a rising stock price hurts earnings, while a declining price helps.

It's easy to understand why executives would be more accepting of the current FASB proposal, since no CEO wants to see the wild swings associated with marking-to-market on their income statement. The irony in this method is that when the share price rises, option-holders win, while shareholders get punished. The beauty of this method is the proof that options align management interests against shareholders, not with them.

Fool contributorChris Mallonthinks this may be the first time he's ever been excited by accounting rules, and he owns none of the companies mentioned here.